Trade and UK politics retain capacity for shock value

A busy week of central bank meetings looms, but only two issues have scope to create a splash across markets. The first is the UK general election on Thursday and the other is the trade negotiations between Washington and Beijing ahead of a US tariff deadline that arrives on Sunday. 

Starting with trade matters, China has provided a clear indication of just how deep the rivalry runs with the US. Beijing demanded over the weekend that all government offices and public institutions must remove foreign computer equipment and software within three years.

This comes as the clock ticks down to December 15, when the US tariffs scheduled to start from that date will either begin, be delayed or removed. Much depends on whether negotiators are close to announcing a skinny deal or “phase-one” by the end of the week. A likely outcome is that the US tariffs are postponed this week via a tweet from the Oval Office.

At the margins, delay over trade does not derail risk appetite, and no one expects any shocks from this week’s meetings of the Federal Reserve and the European Central Bank. 

But analysts at Bank of America Global Research caution that a further delay over a trade deal — one that leaves the December 15 tariffs dangling over negotiations — may not please market sentiment. They explain:

“It prolongs the headline fatigue and arguably reduces China’s incentive to make concessions as delaying tariffs for the second time would be viewed as weakening President Trump’s negotiating hand.”

As for a deal, there remains hope in some quarters of progress in the coming days. 

Ned Rumpeltin at TD Securities reckons:

“A positive phase one deal outcome looks under-priced, in our view — at least in some quarters” and he thinks the Australian dollar — long a barometer of trade concerns — “looks particularly cheap”.

Whether that extends more broadly is tougher to gauge. Equities are priced for progress on trade that restores earnings growth and stronger margins in the coming quarters. This year’s impressive equity rally in broad terms (the FTSE All-World index is up 20 per cent, led by the S&P 500) does look vulnerable if the macro climate does not brighten. 

As noted by JPMorgan: 

“While it’s normal for markets to anticipate the next phase of the business cycle — witness a similarly-sharp surge in the returns of multi-asset portfolio of equities, credit, EM assets and commodities after the 2012 mid-cycle slump, well before measures like global PMIs [purchasing managers’ indices] actually improved — the current overshoot is large enough to imply about 10% drawdown should fundamentals fail to turn.”

Switching gears, the UK votes on Thursday, with the latest opinion polls a boon for the pound, which is knocking on the door of $1.32 versus the dollar, a level not touched since May.

The pound is fairly steady versus the euro, around 84 pence, a level that takes us back to the summer of 2017, but the UK currency remains far from the 70 pence area seen in late-2015. 

Adam Cole at RBC Capital Markets highlights this chart of polling, which suggests a change from the outcome of a hung parliament in 2017. 

Conservative majority 80% priced as Labour start to lag 2017 performance

Still, the big risk, as Adam relates, is that:

“Despite the confidence with which markets predict a Conservative victory, there are still several major uncertainties — turnout (particularly amongst younger voters), potential tactical voting and the large proportion of undecided voters that the polls still show.”

The currency market is not wholly ignoring a polling shock. Caution resonates judging by the action seen in the options market. Implied volatility for one-week options contracts climbed to more than 18 per cent for sterling against the dollar on Monday, nearing its highest levels of the year. In turn, demand for currency put options has surged as shown by this chart, below, for risk reversals over the next week for the pound. This represents the sharpest move in this measure of options trading since early June of 2017, just ahead of the previous general election. Back then, demand for insurance via put options rose ahead of the pound pulling back. The prospect of a repeat performance awaits. 

After the votes are counted, the messy business of a UK trade deal with the EU looms, or, should the polls prove wrong, a lot more downside beckons for the pound. 

Longer term, the latest foreign exchange outlook from Société Générale makes for bleak reading:

“If you’re hoping for Brexit to go away (forever), you may be out of luck. Even if current opinion polls are a good guide (they haven’t been in recent elections) and the UK finally leaves the EU in January 2020, the saga will go on, with at least 11 months of EU/UK trade negotiations ahead. UK interest rates are likely to come down, and sterling is likely to trade in a range against the euro. The pound is still cheap enough that a major fall requires complete failure to negotiate a trade deal with the EU, but a big sterling rally requires good news on the economy that isn’t visible on the horizon.”

Quick Hits — What’s on the markets radar

Demand for cash over year-end remains high as illustrated by Monday’s $43bn of orders for $25bn in 28-day term funding from the Federal Reserve Bank of New York. On Thursday, the FRBNY will provide details about its new monthly repo operations schedule for a period that includes the turn of the year.

Lou Crandall at Wrightson Icap writes:

“The Fed has been saturating the market with repo financing for weeks, and we expect its new monthly operating schedule to feature more of the same. The Fed will leave dealers with no doubt that they will have access to ample funding through the end of the year.”

Lou highlights, via this chart, that dealer borrowing will head beyond the $200bn-$225bn range. 

“As year-end draws closer, however, the total amount of Fed RPs outstanding seems likely to reach new highs. Our guess is that dealers will take down enough of the available funding to boost the total to $250 billion or more in the final 10 days of the year, and that the aggregate amount of Fed repos outstanding will peak at more than $300 billion on the statement date itself.”

The fallout from last week’s Opec meeting has left Brent crude stalled below $65 a barrel. That caps a steady rise from about $57 since October.

Investec questions whether the agreed production cuts can prevent a bout of renewed weakness in the oil price:

“Even if compliance is strong and oil demand grows by 1.2m b/d next year, these cuts may only leave room for supply from other countries to grow by 1.5m b/d which is at the lower end of forecasts. Therefore, Brent may need to move below 60$/b to avoid stimulating too much demand growth.”

Vale, Paul Volcker, 1927-2019. Inflation tamer and whose opinion about modern banking was illustrated by his quip in mid-2009 that the best example of financial innovation in recent decades was the automatic teller machine.